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Us VS LUDEY

Ludey brought this suit in the Court of Claims to recover an amount exacted as additional
taxes for 1917 under the income and excess profits provisions of the Revenue Act of
1916, September 8, 1916, c. 463, Tit. I, 39 Stat. 756-759, as amended by the Revenue
Act of 1917, October 3, 1917, c. 63, 40 Stat. 300, 329. The tax was assessed on the
alleged gain from a sale in 1917 of oil mining properties which had been owned and
operated by him for several years. The Commissioner of Internal Revenue determined
that there was a gain on the sale of $26,904.15. Ludey insists that there was a loss of
$14,777.33. The amount sued for is the tax assessed on the difference. Whether there
was the gain or the loss depends primarily upon whether deductions for depletion and
depreciation are to be made from the original cost in determining gain or loss on sale of
oil mining properties. The question is one of statutory construction or application. The
Court of Claims entered judgment for the plaintiff. 61 Ct.Cls. 126. This Court granted a
writ of certiorari. 271 U.S. 651.

The properties consisted, besides mining equipment, in part of oil land held in fee, in part
of oil mining leases. The aggregate original cost of the properties was $95,977.33. Of this
amount, $30,977.33 was the cost of the equipment used in the business; $65,000 the
cost of the oil reserves. The 1917 sale price was $81,200. For the purpose of determining
the cost of the properties sold in 1917 the Commissioner deducted from the original cost
$10,465.16 on account of depreciation of the equipment through wear and tear, and
$32,258.81 on account of depletion of the reserves through the taking out of oil by the
plaintiff, after March 1, 1913. There was no dispute of fact concerning the correctness of
the estimates upon which these deductions were made. The finding of the depletion was
in accordance with the method of computation employed by the Bureau of Internal
Revenue, and there was no objection specifically to the method of computation. But
Ludey insisted that the amount of depletion, if any, could not be found or stated as a fact,
since, in the nature of the case, it was impossible to determine how much oil was
recoverable, either when he acquired the properties or when he disposed of them. The
finding of the depreciation was, likewise, in accordance with the method of computation
employed by the bureau, and there was no objection to the method of computation. But
Ludey insisted also in respect to depreciation that the property was, as a matter of law,
unchanged in character and quantity throughout the period of operation.

Until 1924, none of the revenue acts provided in terms that, in computing the gain from a
sale of any property, a deduction shall be made from the original cost on account of
depreciation and depletion during the period of operation] But ever since March 1, 1913,
the revenue acts have required that gains from sales made within the tax year shall be
included in the taxable income of the year, and that losses on sales may be deducted
from gross income. And each of the acts has provided that, in computing the taxable
income derived from operating a mine, there may be made a deduction from the gross
income for the depreciation and that some deduction may be made for depletion.
. His contention is that, at the time of the sale in question, Congress had not in terms
required the deductions in the case of any property, and that special reasons exist why
the acts should be construed as not requiring the deductions in the case of oil wells. He
urges that a corporation organized for the purpose of utilizing a wasting property, like an
iron mine, is not deemed to have divided a part of its capital merely because it has
distributed the net proceeds of its mining.

The government contends that, in operating the properties, Ludey disposed, in the form
of oil, of part of his capital assets; that, in the extraction of the oil, he consumed so much
of the equipment as was represented by the depreciation, and disposed of so much of
the oil reserves as was represented by the depletion; that the sale of the properties made
by him in 1917 was not a sale of all of the property represented by the original cost of
$95,977.33, since physical equipment to the amount of the depreciation and oil reserves
to the amount of the depletion had been taken from it during the preceding years, and
that, for this reason, the cost to plaintiff of the net property sold in 1917 was not
$95,977.33, but $53,258.36.

ISSUE

whether, ordinarily, deductions for depreciation and for depletion from the original cost
would be proper in determining whether there had been a profit on a sale of property.

Held

It held that no deduction from original cost should be made here, because of the nature
of oil mining properties. The deduction for depletion was, in its opinion, wrong because
oil properties are, in essence, merely the right to extract from controlled land such oil as
the owner of the right can find and reduce to possession; because the existence of oil in
any parcel of land is dependent upon the movement which the oil makes from time to time
under the surface, and because whether there is oil in place which can be reduced to
possession, and if so, how much, cannot be definitely determined. It held that, in the case
at bar, the right to explore for and take out oil may actually have been more valuable at
the time of the sale than at the time of the purchase, and that, for this reason, the removal
of the oil by plaintiff during the years of operation cannot be said to have depleted the
capital. It held that the depreciation was not deductible, because wear and tear of
equipment was an expense or incident of the business.

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